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Peak Pressure (Extended Version)

Creating oil and natural gas is an amazing process; over
eons, pressure and heat turn tons of organic matter into a usable
fuel. But the process is so slow that every person alive today
will be long gone before the earth creates more fossil fuel. The
peak oil theory suggests that oil production is now in a state of
terminal decline. That notion informs the view of Craig Hodges
who manages
Hodges(HDPMX, 866-811-0224) alongside his father, Donald Hodges. A
multi-cap fund, Hodges is consistently overweight energy relative
to its peer group. We recently spoke with Craig Hodges to discuss
why he's so bullish on the energy sector.

The energy sector has been beaten down recently. Why have you
remained overweight to this sector relative to your
peers?

Under the most optimistic scenario, the world can only produce
about 90 million barrels of oil per day because production depletes
at a rate of 4 percent to 5 percent every year. On top of that,
there are a limited number of rigs available that can actually
drill for oil and a limited number of hydraulic fracturing (frack)
crews that can actually "frack."

When the price of oil hit its all-time high, everyone discussed
how to develop alternative energy sources. But once oil plummeted
to $50 per barrel in 2009, interest in pursuing alternative energy
waned and we remain dependent on oil. We expect oil prices will
eventually climb much higher after China and India resume their
torrid pace of growth.

How far away are we from the day when energy demand
finally exceeds supply?

Some people think that a global recession resulting from the
problems in Europe could cause energy demand to wane. But there are
still roughly 70 million people in China who are about to join the
middle class. They will undoubtedly place new demands on that
country's energy infrastructure.

So it's a foregone conclusion that energy demand will continue
to rise, and we expect to encounter problems with supply within the
next five years. Even though that will lead to higher energy
prices, there are a lot of industries that are going to directly
benefit from such an environment.

Oil prices rebounded by about 30 percent from a year ago,
but equities still seem to be pricing in a recession. What
accounts for this counterintuitive situation?

It's baffling. In September, shares of
Halliburton
(
HAL
) traded at about $58 and oil was around $100 per barrel. Then the
price of oil dipped just below $80 per barrel for a 20 percent
correction, yet Halliburton's stock plunged to $28. Now crude
prices are back in the low $90s, but Halliburton is still off by 40
percent.

When a firm contracts Halliburton or Schlumberger (
SLB
), they're not using the spot price of oil to set the parameters of
the contract; they're relying on three- to five-year estimates.
From our perspective, Halliburton's prospects in the domestic
drilling business are better than ever, but the stock price doesn't
reflect those fundamentals.

In a fairly recent development for the oil market, West
Texas Intermediate (WTI) crude trades at a steep discount to
Brent crude. What's driving that disparity?

WTI is more of a local benchmark based on oil stored in Cushing,
Oklahoma. That oil is trading at a discount because it's available
in greater supply than the oil on the worldwide market.

Such disconnects are usually short-term inefficiencies in the
market. Now that this historically wide discount has garnered such
attention, we expect the spread between WTI and Brent to narrow as
firms take advantage of the discount.

Are current oil prices in the low $90s per barrel good
for the sector?

I think prices between $85 and $95 are a good equilibrium
level.

A lot of businesses have actually adapted to higher oil prices.
For example, if you had told an airline executive five years ago
that he would have to deal with oil at $90 per barrel, he would
have said his airline couldn't be profitable at such a level. But
airlines have restructured their businesses in such a way that they
can be profitable despite the high price of oil.

In fact, this should be a good year for airline profits due to
the changes they've made to accommodate the higher price of oil.
But if oil trades as high as $120 per barrel, then that will create
a whole new problem for that industry.

Of course, companies like Halliburton and
Transocean
(
RIG
) perform quite well in this environment. But at $120 per barrel,
their return on investment would be fantastic. At that threshold,
their day rates increase and all of that excess revenue goes
directly to their bottom line. Conversely, if oil fell to $60 per
barrel it would significantly impair their profits.

Are there any corners of the energy sector that investors
should favor right now?

In the energy industry, we focus on those sub-sectors that have
high barriers to entry because the leaders in these sectors enjoy
pricing power. But overall, the energy business is extremely
diverse and I don't think any one corner of it merits special
attention.

For example, one of our favorite stocks is
Bristow Group
(
BRS
). This undervalued company supplies offshore rigs with
helicopters. We performed a study in which we valued Bristow's
entire fleet of helicopters-there's a bluebook for used helicopters
similar to the one for used cars- and subtracted its debt. Our
resulting valuation of the stock was more than $50. It's trading at
a significant discount to that right now.

But if I had to single out an energy sub-sector, then we favor
deepwater drillers because we expect a hug shortage of rigs
worldwide in 2013. Consequently, the day rates for deepwater rigs
will increase substantially over the next few years. In this
environment, companies such as
Atwood Oceanics
(
ATW
) and Transocean should do quite well. Deepwater drillers don't
trade at high multiples to earnings, as most are priced at less
than 10 times earnings.

Could you elaborate on what's attractive about this
deepwater theme?

Deepwater drillers are almost like a technology play. We're
discovering oil in places that will require extraordinary efforts
to extract it. The technology that enables rigs to extract oil from
fields that are 10,000 feet below the surface of the ocean is
simply amazing. Of course, the advances in seismic technology that
led to these discoveries are also noteworthy.

We recently saw a map that shows deepwater oil field discoveries
that span the globe. If our thesis plays out, every single one of
these discoveries will be drilled for oil. That should lead to a
real shortage of deepwater rigs.

Although there are a bunch of rigs slated for completion in
2014, the industry still has high barriers to entry. That's largely
why we favor this corner of the energy sector. If a firm wants to
enter the deepwater drilling sector, it will need five to seven
years to build a deepwater rig at a cost of around $700 million.
There are only a few companies that have the capital and the
expertise to do that.

Does the price of oil really drive demand in the
deepwater space?

Deepwater drilling can be problematic when a firm is dealing
with the difficulties of extracting oil through 10,000 feet of
water and coping with terrible weather off the coasts of
politically unfriendly countries. But when oil prices are high
enough, some of these gigantic deepwater oil fields can really pay
off.

Additionally, technology is allowing oil companies a greater
degree of comfort in determining whether these deposits are worth
the risk of investing in their extraction. Still, high oil prices
are necessary for such efforts to be sustained; it's not economic
for firms to do deepwater drilling with oil at $60 per barrel. But
at $100 per barrel, we should see as much drilling as the market
can bear.

Can you tell us about a few more of your favorite energy
plays?

Halliburton is one of my favorite large-cap names because it's a
play on the domestic drilling business. We're making some
remarkable energy discoveries in the US and the new shale plays in
places like South Dakota are tremendous.

Although it's a controversial method, fracking enables us to
extract energy deposits from these shale plays, and Halliburton is
the Cadillac of the fracking business. Companies that spend
millions of dollars to develop a well won't waste their time with
the lowest-cost bidder. When they want the very best expertise
brought to bear, they hire Halliburton.

At the moment, there is so much demand for fracking services,
that firms with new drilling prospects are waiting four or five
months for a fracking crew. Of course, Halliburton has other
aspects to its business beyond fracking, but it is well positioned
in the domestic drilling business. And if there's turnover in the
White House, a different administration maybe more amenable to
developing our domestic resources.

In the deepwater arena, Transocean is my favorite play. It has
50 percent of the world's deepwater rigs, and once there's a
shortage of rigs, their day rates should skyrocket. That excess
cash should drop directly to the company's bottom line and drive
their earnings growth. Transocean also offers investors a 5.5
percent dividend yield while they wait for the stock to
appreciate.

Do Halliburton and Transocean face any liability from
their involvement int the BP oil spill in the Gulf of
Mexico?

I think there is a discount in the shares of both companies
since they still have the taint of association with the BP spill.
But lawyers who have expertise in this arena say it's unlikely that
these two firms have any liability for what transpired.

The contracts used in their business are standard for the
industry and they basically indemnify anyone but the operator--in
this case BP--from any liability. Under those contracts, BP tells
Transocean and Halliburton exactly what to do and how and when to
do it, so BP bears all the legal risk. And we haven't seen any of
these contracts abrogated for such problems in the past. So this
unfair stigma is actually an opportunity for investors.

Are there any other energy plays you find
compelling?

Many people are familiar with
Chesapeake Energy
(CHK) and its CEO Aubrey McClendon, who is a bit of a lightning
rod. Chesapeake was started by McClendon and Tom Ward. McClendon
was the sizzle and Ward was the steak. Ward's not very high
profile, but he's a very good land man and a very good executive
with a lot of credibility. He's easily one of the best in the
business.

SandRidge Energy
(SD) was founded by Ward in 2007, so it's similar to Chesapeake.
About three years ago, natural gas accounted for roughly 80 percent
of the firm's production. As an example of how effective Ward is as
an operator, he realized there was a glut of natural gas that would
make it unprofitable for his firm to maintain this production mix.
While other companies like Chesapeake maintained their focus on
natural gas production, Ward reoriented SandRidge's production so
that it's now 80 percent oil. Investors haven't realized that
yet.

SandRidge has acquired a huge tract of land in Oklahoma called
the Mississippi Lime play and is the leader in that geography with
over 1 million acres. The firm is also drilling a lot of shallow
wells in the Permian Basin. These are all low risk, inexpensive
wells. Ward is borrowing money to drill them, but has earned 80
percent to 90 percent returns on these wells.

From the start, Ward has done everything he's promised. But
there are a lot of people who doubt that he can continue his
aggressive drilling because the company has borrowed substantial
amounts of money. There's some merit to that argument because the
firm is unable to develop all its plays due to its capital
expenditures.

But Ward has mapped out a clear, sensible financing plan for
future drilling. We think his strategy will be proven right. So
it's a controversial play, but I think it makes a lot of sense,
particularly at current prices.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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